The Paid Piper of Hamelin

The title is from the childhood story where the Pied Piper helped a town get rid of the rats and drowned them in the river by playing his melodious music. The second part of the story is that after the rats were got rid of, the town did not pay him. So a very sad thing happened as he came back revengeful and wooed the children away.

I wish to relate this to the largest debt we take on in our lives, Home Mortgage.

One’s own home is a dream which everyone loves to live, but the mortgage is like the rat which becomes ubiquitous in our entire life (for 30 years and everyone holds one in his/her financial life).

The mortgage is usually a large amount (2-3x of annual salary) and the long period makes us imitate the Pied Piper with our finances.

The big question is should you pay up the mortgage, never have one at all, or let it continue while you build wealth by investing?

Mortgage has a number of factors – the monthly payment, interest rates, tax benefits, prepayment charges, points, refinance, fixed and adjustable, ARM and LEG and what not.

There are entire books on mortgage terms, strategies and nuances. Also there are countless arguments on which is better – paying off mortgage or investing the same money at higher risk/return.

The question is how do we become a Paid Piper from a Pied Piper? How do we get that relief when the rats are drowned? Or is life worth it when the rats are gone and the music has to stop? Will you feel betrayed like the Pied Piper once all your savings (hard work) are trapped between the walls?

This is a question I searched extensively for a solution but could not find any conclusive resources or guidelines.

Very recently as I bought a house in Texas, I have considered a number of strategies based on my prevailing financial situation.

I have no finance degree nor do I work in a bank or financial institution. But over the years I faced this question multiple times as I owned 3 houses (India and US), all bought with a mortgage and then paid up fully or partially.

This post is just to systematize this complex decision by taking into account a few personal finance factors. I hope this will help you make a better decision if you are grappling with the same question.

You can be in 3 situations that I have gone through and used all 3 strategies in the 3 real estate possessions.

Lets call it A – The Paid Piper solution. You throw all your extra money towards the mortgage and pay it up as soon as possible. This is also the Dave Ramsey way, where Baby Step 6 says after you are consistently investing 15% of your salary and saving for kids education, you should throw all your extra money towards mortgage and become completely debt-free.
Lets call it B – The Pied Piper solution. Here you keep paying the mortgage payment every month but also pay a little fixed extra, to keep chipping away at the principal. Although you can throw even more money, but you prefer to invest the extra money into stocks and REITs. Keep the music on and lead the rats slowly towards the river. Hopefully you earn from the residents of the town as they enjoy the music but gets rat-free as well. 🙂
Lets call it C – The Rat Lover solution. Here the rat is kept controlled (by making regular payments only) and the music plays on for a long time and creates enough entertainment that the rat problem diminishes from the people’s mind. In other words, the mortgage is kept alive by making the payments while the investment portfolio (real estate or otherwise) keeps growing by acquiring more assets.

Now let us see what factors in your financial situation will or should make you follow either A, B or C strategies. These factors will never be exhaustive but the ones I am going to discuss are faced by me and used in my decision in all the 3 cases. You can apply them to your situation and according to your long term goals.

A – The Paid Piper of Hamlin

The mortgage interest rate is very high compared to investment returns. An interest rate above 8% is almost always expensive as you will struggle to earn 8% on your money consistently from regular investments like stocks, ETF or mutual funds. It is a no-brainer that you should pay off as soon as possible, or refinance to a lower interest rate. If you manage to refinance, congratulations. You can follow B or C below.
- This was my situation in the first house I bought in India where the interest rates were > 10%. I paid off the mortgage in little over 3 years as I absolutely hated the monthly payments and the stress on my budget. 10 years later, I still own the house which is now giving me a nice rental income with zero loan costs.
You have a decent rate 5-6% but not very low. You are not comfortable with debt and you really want to stay in the house for long term (10-15 years). This is your dream house and owning it free and clear will give you a peace of mind and pride too. By all means strive to pay it off.
- This is Dave Ramsey way where he says wealth starts building up and you become generous when you have no more monthly payments.
But most important is to also look at your overall asset allocation if you have an affordable mortgage. How much do you have in Stocks and Bonds? A simple allocation is 33% Stocks, 33% Bonds and 33% real estate. You can modify the percentages according to your risk profile and age, but you get the idea.
- Decide on an asset allocation and calculate where do your investments stand. Take into account the Equity you already have in this home as Real Estate. If putting more money into the Home is not going to disrupt your asset allocation and actually help build up the Real Estate Equity, go for paying up on the mortgage.
- Be careful on this as you don’t want to be House Poor, where Real Estate allocation is like 80-90% and you are left with very little liquid investments. This can be really stressful when the economy is down and chances of emergency situations and job loss increase. Also not having cash means you will miss on the great investment opportunities that comes up during recession times.
All the above factors were justified in my case of my first house mortgage.
- I had a high interest rate loan then and I did not see any way of refinancing. It was not so common those days or I did not bother.
- I wanted to sleep better and own my first house. I happily stayed in the house for more than 10 years, paid it up and rented out when I moved to my second abode.
- I was building my portfolio and paying it off just made the Real Estate part done. There was no REIT in India (they are coming now), and so the only real estate exposure was to buy a physical asset.

B – The Pied Piper of Hamlin

Here you play along but also have the task of paying off your mortgage in your plans.

This can be the real balanced approach and most financial advisers recommend this. You will read over the Internet about the biweekly plan, HELOC strategy, monthly extra payment etc. All these are good but lets see when you should employ this strategy.

You have a decent mortgage rate of 5-6% and you are a disciplined investor.
You budget every month and have the discipline not to blow up the extra money.
You are inspired by Dave Ramsey and you know after investing 15% of your salary into retirement accounts and investing for kid’s education, you have surplus that you can throw at the mortgage.
- However this requires a lot of discipline and so Dave recommends a 15 year mortgage so that you are forced to increase your monthly payments.
I am a big fan of asset allocation. The beauty of this approach is that you can tweak the extra payments to balance your assets between Stocks, Bonds and Real Estate. If your real estate allocation is low, increase your extra payments and as the allocation comes closer to your desired one, reduce your payments and so on.
When I purchased my second house in India, I paid majority by cash (as interest rates are still high in the range of 8-9%) and took out a loan for the rest.
- This let me continue investing in mutual funds and fixed deposits, while the mortgage payment earned me equity and further added to the Real Estate allocation.
- I also paid extra every month due to following factors.
  - The house was brand new construction and my wife and daughter designed the interior beautifully. So we did not plan to sell it soon, but instead, planned to stay in it for the long haul like our first house. I eventually wanted to own it free and clear again.
  - The interest was high (typical in India) although the payment fit into my budget. The extra payment I could customize month to month and throw into the principal.
  - I could keep investing in mutual funds according to my worked out allocation, and at the same time apply for tax deductions on the mortgage interest.
- However situations changed in about 3 years. We could not stay in this house for long, as my job required me to relocate to US.
  - Paying off suddenly became a priority if I had to keep the house.
  - Well I could have sent money from US every month, but that would have disrupted my other plans. More on that in later posts.
  - Due to complex international tax laws, I had to liquidate some of the mutual fund investments. It made sense to pay off the house than letting the money idle in savings accounts.
So if you have the discipline of working on a budget, you can chip away extra on your mortgage principal with two goals in mind.
- Increase your Stocks and Bonds portfolio as you invest majority of your savings, thus keeping your asset allocation sane. The real estate down payment (typically 20%) itself creates a big skew in asset allocation. So you want to tune the extra monthly payments according to the asset allocation.
- Eventually you want to pay off as you want to keep the house for long term.

C- The Rat Lover

Yikes!! Who loves a Rat? The investors of course… They love leverage and want their tenants to handle the rat, while they enjoy the music in terms of cash flow and asset appreciation. If you are really interested in this mode, I suggest read a lot of Real Estate Investment material to learn how to do it properly.

I have not done it intentionally but I have read a lot (I still scourge for such books and BiggerPockets.com).

In the USA, the real estate investing is popular due to the rent/value ratio being investor friendly in some regions and the overall mortgage rates are quite low.

So even if you maintain a mortgage, either the rent or your monthly budget can cover it. Of course, you should plan and budget well, and buy the house you can afford.

Now when should you play the Rat Lover? Dave Ramsey will not advocate this at any cost unless you are working on other high interest debt or you have no financial slack in your budget to pay off. The simple reason is this is risky and if you run into financial trouble, your beloved home can go into foreclosure.

But there is a deliberate situation of not paying off. I am not talking about real estate investing but as a homeowner like me. I bought my property in Texas in December 2017.

Here are the considerations and why I decided to adopt this 3rd strategy.

Since I did not have a credit score (no history in US), I could get a 7/1 ARM with a 3.625% interest rate. This was good as it perfectly fit into my budget owing to the low rate.
I did not then plan to keep the house for long term. It was a starting house in the US and everyone told me we will upgrade in a few years time (less than 7 years and hence the 7/1 ARM). So there is no point in driving down the mortgage with extra payments (except to save some interest).
Instead I should invest the surplus out of my budget in low cost index funds and increase my asset allocation. Note in my second house, as I liquidated some investments and paid off mortgage, my asset allocation is really screwed up hugely in favor of Real Estate.
Me and my wife renovated this house in Texas and brought the value up. I have not done an appraisal yet but I am sure it improved value by 10-15%. So now we want to keep this house for the long term. Even if we move out or move to another place, we can convert it to a rental as the mortgage interest rate is low.
Now there are two ways to hold this house long term.
- I can focus on paying down the 7/1 ARM before it becomes adjustable and hits me with the interest rate risk (it will start floating in the 8th year). But this would have skewed my asset allocation further towards Real Estate.
- I can refinance it to a fixed rate (now that I have a credit score and a decent one). I did exactly this and refinanced this month (the rates took quite a dip). Of course I could not get as low as the 7/1 ARM but very close to not affect the monthly payment too much.
Now I can invest entire savings every month and build up a portfolio of index funds. Once my asset allocation comes back in shape I will go back to strategy B and start paying off the mortgage.

Conclusion

Lets consolidate the factors and see if we can come up with a situational formula to decide what kind of Piper you will be.

Type A: The Paid Piper

You have a high interest mortgage. Always try to refinance to lower rates though.
Your asset allocation dictates you to increase the Real Estate portion. The principal payments towards your mortgage goes towards building the Equity.
You either have substantial liquid assets or are investing regularly to increase stocks and bonds allocation.
You want to stay in the house for long term and owning it free and clear will give you the peace of mind.

Type B: The Pied Piper

You have a decent mortgage interest rate (5-6 %) and can comfortably handle the monthly payments.
Your asset allocation is already balanced and real estate equity build-up is a part of your regular investment plan.
You plan to stay in the house for a longer duration, if not forever.

Type C: The Rat Lover

You have a good mortgage interest rate (< 5%). You obviously can comfortably handle the monthly payments.
Your asset allocation is already skewed towards Real Estate and adding more home equity will make your portfolio ill-liquid.
You have alternative plans of either converting this to a rental or you bought this property as an investment. Of course you should know how to manage rentals to generate positive cash flow.
You may move out of town or country in few years (the time is not fixed). You will have a choice then to sell it off or convert it to a rental. The fixed rate will not cause a change in your asset allocation or worry about interest rate movements.

Here are my 3 units portfolio.